What is an Exchange-Traded Fund (ETF)?

An ETF is like an investment smoothie…

Similar to a smoothie, it’s one thing you can invest in that’s made up of a mix of ingredients. ETFs are available in different asset flavors (i.e., they may track different industries, sectors, or types of companies).

Smoothies come in a variety of flavors, sizes, and tastes — ETFs are similar. Sometimes they track stock indexes, such as the S&P 500. But they can also provide access to other types of securities. For example, you can also find ETFs that track an underlying mix of currencies (foreign money), bonds (corporate debt), or even commodities (such as undifferentiated products, like oil or orange juice).

Some common ETFs include:

• Broad index-based ETFs: These are intended to track popular indexes like the S&P 500 stock index, which is made up of 500 of the largest publicly traded US companies based on their value by market capitalization. It offers a certain taste of the general US stock market (i.e., large-cap stocks). This ETF typically rises and falls in a closely correlated fashion with the S&P 500 stock index.
• Sector or niche ETFs: These ETFs can track a more narrow part of the market as either a speculative 'bet' on a certain market segment, or as a way to diversify an existing group of securities (i.e. stocks, bonds, etc.). These types of ETFs can represent unique market segments like commodities (e.g., gold, oil), or they can specialize in a narrower segment of a larger class of assets (e.g., small companies, foreign companies, or cybersecurity companies). But investors in these ETFs are typically exposed to additional political, currency, and market risks.

Both contain the word “fund,” but they’re not exactly the same. Mutual funds and ETFs similarly can provide access or exposure to a wider range of investments in one, bundled, fund. Mutual funds also come in two primary types (open-ended and close-ended), which can each offer different characteristics. But while ETFs and mutual funds both provide investment diversification, they differ in their structure, their benefits, and their risks.

Here are a couple differences:

1. An ETF can be traded throughout the day on exchanges, like a stock. But many mutual funds (like open-ended mutual funds) are only priced once daily, at the end of a trading day, and can only be redeemed after that price is determined daily once trading ends.
2. ETFs are often designed to passively track a particular industry, index, or bundle of securities, so management fees can be lower.

ETFs provide a variety of benefits relative to other types of funds, such as mutual funds. Keep in mind that despite these advantages, all ETFs carry risk based on the underlying investments they hold (and which you, as the investor, would gain exposure to as a holder of an ETF, for instance):

• “Intraday” trading: Just like a stock, ETF prices can move during the day and ETFs can be bought and sold during trading hours. For example, a day trader may buy an ETF in the morning, sell it at lunch, and re-buy it in the afternoon. An open-ended mutual fund, on the other hand, can only be redeemed once a day, after the market closes, at the fund’s end-of-day price.
• Lower fees: Mutual funds may be actively managed by a fund manager, and in that case they typically charge higher fees for this service. But since ETFs often passively track the movements of an index or security without as much active human direction, they typically don’t charge as much of a management fee. Some ETFs are actively managed.
• Diversification: The wide variety of ETFs available can make it easier to provide diversification to your portfolio. Different and increasingly niche ETFs specialize in certain sectors, areas, and securities that can help balance out your other investments.

Investing is serious, no matter the type of investment — stocks, commodities, mutual funds, or ETFs. In addition to an ETF’s benefits, there are also some disadvantages to keep in mind. And just like any investment, ETFs carry risk, whether that’s the risk generally associated with investing in the financial markets, or or the specific risk of the companies in which it’s invested.

Here are some key disadvantages to keep in mind:

• Variety: While ETFs may help diversify a portfolio, they aren’t necessarily diverse on their own.Some ETFs provide access to a wide variety of stocks within a specific region, sector, or topic, but not all do. Make sure you’re aware of exactly what the ETF in which you’re investing includes and whether that actually diversifies your investments, if that’s what you’re aiming for.
• Market instability: Over the last decade, the growing popularity of ETFshas resulted in a surge of funds tracking various indices or industries. As a result, some research suggests that market volatility can be amplified because of the algorithm-driven investments by some of the funds.
• Tradeability: ETFs can trade throughout the day like a stock, but that doesn’t mean they’re all necessarily easy to trade. Some ETFs that focus on more niche or obscure sectors may have relatively few buyers and sellers, making it harder to trade your ETF shares quickly at a price you want.
• Leverage and Volatility: Some ETFs are designed to amplify the moves of the market — picture that smoothie, but loaded with caffeine. One could be structured to track the broader market, but it might be leveraged so that it rises 3x what the index did — remember though, that also means it falls by three times the amount when markets turn down. Caffeine highs can lead to caffeine crashes. These risky, leveraged or inverse ETFs are generally used by short-term traders.